ECN204 STUDY NOTES

CHAPTER ONE: LIMITS, ALTERNATIVES, and CHOICES

Economics examines how individuals, institutions, and society makes choices under conditions of scarcity

The economic way of thinking stresses (a) resource scarcity and the necessity of making choices, (b) the

assumption of purposeful (or rational) behavior, and (c) comparisons of marginal benefit and marginal cost.

In choosing among alternatives, people incur opportunity costs

In choosing the best option, people incur opportunity costs – the value of the next best option

Economists use the scientific method to establish economic theories, cause-effect generalizations about the

economic behavior of individuals and institutions

Microeconomics focuses on specific units of the economy; macroeconomics examines the economy as a

whole

Positive economics deals with factual statements (―what is‖); normative economics involves value judgments

(―what ought to be‖)

Because wants exceed incomes, individuals face an economic problem: they must decide what to buy and

what to forgo

A budget line (budget constraint) shows the various combinations of two goods that a consumer can purchase

with a specific money income

Straight-line budget constraints imply constant opportunity costs associated with obtaining more of wither of

the two goods

Economists categorize economic resources as land, labour, capital, and entrepreneurial ability

The PPC illustrates the (a) scarcity of resources, implied by the area of unattainable combinations of output

lying outside the PPC; (b) choice among outputs, reflected in the variety of attainable combinations of goods

lying along the curve; (c) opportunity cost, illustrated by the downward curve of the slope; and (d) the law of

increasing opportunity costs, reflected in the bowed-outward shape of the curve

A comparison of marginal benefits and marginal costs is needed to determine the best or optimal output mix

on a PPC

Unemployment causes an economy to operate a point inside its PPC

Increases in resource supplies, improvements in resource quality, and technological advances cause economic

growth, which is depicted as an outward shift of the PPC

An economy’s present choice of capital and consumer goods helps determine the future location of its PPC

International specialization and trade enable a nation to obtain more goods than its PPC would indicate

Optimal Allocation: MB = MC

Optimal allocation requires the expansion of a

good's output until its marginal benefit (MB)

and marginal cost (MC) are equal. No resources

beyond that point should get allocated to the

product. Here, allocative efficiency occurs when

200,000 pizzas are produced.

Unemployment, Productive Inefficiency, and the

Production Possibilities Curve

Any point inside the production possibilities curve,

such as U, represents unemployment or a failure to

achieve productive efficiency. The arrows indicate

that, by realizing full employment and productive

efficiency, the economy could operate on the curve.

This means it could produce more of one or both

products than it is producing at point U.

Economic Growth and the Production Possibilities Curve

The increase in supplies of resources, the improvements in resource quality, and the technological advances that

occur in a dynamic economy move the production possibilities curve outward and to the right, allowing the

economy to have larger quantities of both types of goods.

Present Choices and Future Locations of a Production Possibilities Curve

A nation's current choice favouring ―present goods,‖ as made by Presentville in part (a), will cause a modest

outward shift of the curve in the future. A nation's current choice favouring ―future goods,‖ as made by

Futureville in part (b), will result in a greater outward shift of the curve in the future.

CHAPTER FOUR: INTRODUCTION TO MACROECONOMICS

Macroeconomics studies long-run economic growth and short-run economic fluctuations.

Macroeconomists focus their attention on three key economic statistics: GDP, unemployment, and

inflation. GDP is the dollar amount of all final goods and services produced in a country during a given

period of time. The unemployment rate measures the percentage of all workers who are not able to find

paid employment despite being willing and able to work. The inflation rate measures the extent to which

the overall price level is rising in the economy.

Before the Industrial Revolution, living standards did not show any sustained increases over time.

Economies grew, but any increase in output tended to be offset by an equally large increase in

population, so that the amount of output per person did not rise. By contrast, since the Industrial

Revolution began in the late 1700s, many nations have experienced modern economic growth in which

output has grown faster than population—so that standards of living have risen over time.

Macroeconomists believe that one of the keys to modern economic growth is the promotion of saving and

investment (for economists, the purchase of capital goods). Investment activities increase the economy's

future potential output level. But investment must be funded by saving, which is possible only if people

are willing to reduce current consumption. Consequently, individuals and society face a trade-off

between current consumption and future consumption. Banks and other financial institutions help to

convert saving into investment by taking the savings generated by households and lending them to

businesses that wish to make investments.

Expectations have an important effect on the economy for two reasons. First, if people and businesses are

more positive about the future, they will save and invest more. Second, individuals and firms must adjust

to shocks—situations in which expectations are unmet and the future does not turn out the way people

were expecting. In particular, shocks often imply situations where the quantity supplied of a given good

or service does not equal the quantity demanded of that good or service.

If prices were always flexible and capable of rapid adjustment, then dealing with situations in which

quantities demanded did not equal quantities supplied would always be easy since prices could simply

adjust to the market equilibrium price at which quantities demanded do equal quantities supplied.

Unfortunately, real-world prices are often inflexible (or ―sticky‖) in the short run so that the only way for

the economy to adjust is through changes in output levels.

―Sticky‖ prices combine with shocks to drive short-run fluctuations in output and employment. Consider

a negative demand shock in which demand is unexpectedly low. Because prices are fixed, the lower-

than-expected demand will result in unexpectedly slow sales. This will cause inventories to increase. If

demand remains low for an extended period of time, inventory levels will become too high and firms will

have to cut output and lay off workers. Thus, when prices are inflexible, the economy adjusts to

unexpectedly low demand through changes in output and employment rather than through changes in

prices (which are not possible when prices are inflexible).

Prices are inflexible in the short run for various reasons, two of which are discussed in this chapter. First,

firms often attempt to set and maintain stable prices in order to please customers (who like predictable

prices because they make for easy planning, and who might become upset if prices were volatile).

Second, a firm with just a few competitors may be reluctant to cut its price due to the fear of starting a

price war, a situation in which its competitors retaliate by cutting their prices as well—thereby leaving

the firm worse off than it was to begin with.

The Effect of Unexpected Changes in Demand under

Flexible and Fixed Prices

(a) If prices are flexible, then no matter what demand

turns out to be, Buzzer Auto can continue to sell its

optimal output of 900 cars per week since the

equilibrium price will adjust to equalize the quantity

demanded with the quantity supplied.

(b) By contrast, if Buzzer Auto sticks with a fixed

price policy, then the quantity demanded will vary

with the level of demand. At the fixed price of

$37,000 per vehicle, the quantity demanded will be

700 cars per week if demand is DL, 900 cars per

week if demand is DM, and 1150 cars per week if

demand is DH.

CHAPTER FIVE: MEASURING THE ECONOMY’S OUTPUT

Gross domestic product (GDP), a basic measure of economic performance, is the market value of all final

goods and services produced within the borders of a nation in a year.

Final goods are those purchased by end users, whereas intermediate goods are those purchased for resale or

for further processing or manufacturing. Intermediate goods, nonproduction transactions, and second-hand

sales are purposely excluded in calculating GDP.

GDP may be calculated by summing total expenditures on all final output or by summing the income derived

from the production of that output.

By the expenditures approach, GDP is determined by adding consumer purchases of goods and services,

gross investment spending by businesses, government purchases, and net exports: GDP = C + Ig + G + Xn.

Gross investment is divided into (a) replacement investment (required to maintain the nation's stock of capital

at its existing level), and (b) net investment (the net increase in the stock of capital). Positive net investment

is associated with an expanding production capacity, negative net investment with a declining production

capacity.

Personal consumption expenditures consist of expenditures on goods (durable goods and nondurable goods)

and services. About 60 percent of consumer expenditures in Canada are on services, leading economists to

refer to the Canadian economy as a service economy.

By the income approach, GDP is calculated as the sum of wages and salaries, profits of corporations and

government enterprises before taxes, interest and investment income, net income of farmers and

unincorporated businesses, and the two noninvestment transactions (indirect taxes less subsidies and capital

consumption allowances).

Price indexes are computed by dividing the price of a specific collection or market basket of output in a

particular period by the price of the same market basket in a base period and multiplying the result (the

quotient) by 100.

The implicit price index, or GDP deflator, is used to adjust nominal GDP for inflation or deflation and

thereby obtain real GDP.

Nominal (current-dollar) GDP measures each year's output valued in terms of the prices prevailing in that

year. Real (constant-dollar) GDP measures each year's output in terms of the prices that prevailed in a

selected base year. Because real GDP is adjusted for price-level changes, differences in real GDP are due

only to differences in production activity.

A chain-weighted index to compute real GDP is constructed using an average of current and past prices as

weights. It is particularly useful in an economy in which the prices of some outputs are declining.

GDP is a reasonably accurate and very useful indicator of a nation's economic performance, but it has

limitations. It fails to account for nonmarket and illegal transactions, changes in leisure and in product

quality, the environmental effects of production, and the composition and distribution of output. GDP should

not be interpreted as a complete measure of well-being.

CHAPTER SIX: ECONOMIC GROWTH

A nation's economic growth can be measured either as an increase in real GDP over time or as an increase in

real GDP per capita over time. Real GDP in Canada has grown at an average annual rate of about 3.3 percent

since 1961; real GDP per capita has grown at roughly a 2.1 percent annual rate over that same period.

Sustained increases in real GDP per capita did not happen until the late 1700s, when England and then other

countries began to experience modern economic growth, which is characterized by institutional structures that

encourage savings, investment, and the development of new technologies. Institutional structures that

promote growth include strong property rights, patents, efficient financial institutions, education, and a

competitive market system.

Because some nations have experienced more than two centuries of economic growth while others have

begun to experience economic growth only recently, some countries today are much richer than other

countries.

It is possible, however, for countries that are currently poor to grow more quickly than countries that are

currently rich because the growth rates of rich-country GDPs per capita are limited to about 2 percent per

year. In order to continue growing, rich countries must invent and apply new technologies. By contrast, poor

countries can grow much more quickly because they can simply adopt the institutions and cutting-edge

technologies already developed by the rich countries.

The determinants of economic growth responsible for changes in growth rates include four supply factors

(increases in the quantity and quality of natural resources, increases in the quantity and quality of human

resources, increases in the supply (or stock) of capital goods, and improvements in technology); one demand

factor (increases in total spending); and one efficiency factor (increases in how well an economy achieves

allocative and productive efficiency).

The growth of a nation's capacity to produce output can be illustrated graphically by an outward shift of its

production possibilities curve.

Growth accounting attributes increases in real GDP either to increases in the amount of labour being

employed or to increases in the productivity of the labour being employed. Increases in Canada's real GDP

are mostly the result of increases in labour productivity. The increases in labour productivity can be attributed

to technological progress, increases in the quantity of capital per worker, improvements in the education and

training of workers, the exploitation of economies of scale, and improvements in the allocation of labour

across different industries.

Over long time periods, the growth of labour productivity underlies an economy's growth of real wages and

its standard of living.

Canada's real GDP has grown partly because of increased inputs of labour and primarily because of increases

in the productivity of labour. The increases in productivity have resulted mainly from technological progress,

increases in the quantity of capital per worker, improvements in the quality of labour, economies of scale, and

an improved allocation of labour.

Over long time periods, the growth of labour productivity underlies an economy's growth of real wages and

its standard of living.

The post-1995 productivity growth is based on rapid technological change in the form of the microchip and

information technology; new firms, increasing returns, and lower per-unit costs; and heightened global

competition that holds down prices.

The main sources of increasing returns in recent years are (a) use of more specialized inputs as firms grow,

(b) the spreading of development costs, (c) simultaneous consumption by consumers, (d) network effects, and

(e) learning-by-doing. Increasing returns mean higher productivity and lower per-unit production costs.

Skeptics wonder if the rise in the average rate of productivity growth is permanent. They point out that surges

in productivity and real GDP growth have previously occurred but do not necessarily represent long-lived

trends.

Critics of rapid growth say that it adds to environmental degradation, increases human stress, and exhausts

the earth's finite supply of natural resources. Defenders of rapid growth say that it is the primary path to the

rising living standards nearly universally desired by people, that it need not debase the environment, and that

there are no indications we are running out of resources. Growth is based on the expansion and application of

human knowledge, which is limited only by human imagination.

CHAPTER SEVEN: BUSINESS CYCLES, UNEMPLOYMENT, and INFLATION

Canada and other industrial economies have gone through periods of fluctuations in real GDP,

employment, and price level. Although they have certain phases in common—peak, recession, trough,

expansion—business cycles vary greatly in duration and intensity.

Although economists explain the business cycle in terms of underlying causal factors such as major

innovations, productivity shocks, money creation, and financial crises, they generally agree that the level

of total spending is the immediate determinant of real output and employment.

The business cycle affects all sectors of the economy, though in varying ways and degrees. The cycle has

greater effects on output and employment in the capital goods and durable consumer goods industries

than in the services and nondurable goods industries.

Economists distinguish among frictional, structural, cyclical, and seasonal unemployment. The full-

employment or natural rate of unemployment, which is made up of frictional and structural

unemployment, is currently 6–7 percent. The presence of part-time and discouraged workers makes it

difficult to measure unemployment accurately.

The GDP gap, which can be either a positive or a negative value, is found by subtracting potential GDP

from actual GDP. The economic cost of unemployment, as measured by the GDP gap, consists of the

goods and services forgone by society when its resources are involuntarily idle. Okun's law suggests that

every increase in unemployment by 1 percent above the natural rate causes an additional 2 percent

negative GDP gap.

Unemployment rates vary widely globally. Unemployment rates differ because nations have different

natural rates of unemployment and often are in different phases of their business cycles.

Inflation is a rise in the general price level and is measured in Canada by the Consumer Price Index

(CPI). When inflation occurs, each dollar of income will buy fewer goods and services than before. That

is, inflation reduces the purchasing power of money.

Economists distinguish between demand–pull and cost–push (supply-side) inflation. Demand–pull

inflation results from an excess of total spending relative to the economy's capacity to produce. The main

source of cost–push inflation is abrupt and rapid increases in the prices of key resources. These supply

shocks push up per-unit production costs and ultimately the prices of consumer goods.

Unanticipated inflation arbitrarily redistributes real income at the expense of people with a fixed income,

creditors, and savers. If inflation is anticipated, individuals and businesses may be able to take steps to

lessen or eliminate adverse redistribution effects.

When inflation is anticipated, lenders add an inflation premium to the interest rate charged on loans. The

nominal interest rate thus reflects the real interest rate plus the inflation premium (the expected rate of

inflation).

Cost–push inflation reduces real output and employment. Proponents of zero inflation argue that even

mild demand–pull inflation (1–3 percent) reduces the economy's real output. Other economists say that

mild inflation may be a necessary by-product of the high and growing spending that produces high levels

of output, full employment, and economic growth.

Hyperinflation, caused by highly imprudent expansions of the money supply, may undermine the

monetary system and cause severe declines in real output.

CHAPTER EIGHT: BASIC MACROECONOMIC RELATIONSHIPS

Other things equal, a direct (positive) relationship exists between income and consumption and income and

saving. The consumption and saving schedules show the various amounts that households intend to consume

and save at the various income and output levels, assuming a fixed price level.

The average propensities to consume and save show the fractions of any total income that are consumed and

saved: APC + APS = 1. The marginal propensities to consume and save show the fractions of any change in

total income that is consumed and saved: MPC + MPS = 1.

The locations of the consumption and saving schedules (as they relate to real GDP) are determined by (a) the

amount of wealth owned by households; (b) expectations of future income, future prices, and product

availability; (c) the relative size of household debt; and (d) taxation. The consumption and saving schedules

are relatively stable.

The immediate determinants of investment are (a) the expected rate of return and (b) the real interest rate.

The economy's investment demand curve is found by cumulating investment projects, arraying them in

descending order according to their expected rates of return, graphing the result, and applying the rule that

investment will be profitable up to the point at which the real interest rate, i, equals the expected rate of

return, r. The investment demand curve reveals an inverse relationship between the interest rate and the level

of aggregated investment.

Shifts in the investment demand curve can occur as the result of changes in (a) the acquisition, maintenance,

and operating costs of capital goods; (b) business taxes; (c) technology; (d) the stocks of capital goods on

hand; and (e) expectations.

Either changes in interest rates or shifts in the investment demand curve can shift the investment schedule.

The durability of capital goods, the variability of expectations, and the irregular occurrence of major

innovations all contribute to the high fluctuations in investment spending.

Through the multiplier effect, an increase in investment spending (or consumption spending, government

purchases, or net export) ripples through the economy, ultimately creating a magnified increase in real GDP.

The multiplier is the ultimate change in GDP divided by the initiating change in investment or some other

component of spending.

The multiplier is equal to the reciprocal of the marginal propensity to save: the greater the marginal

propensity to save, the smaller the multiplier. Also, the greater the marginal propensity to consume, the larger

the multiplier.

Economists disagree on the size of the actual multiplier in Canada, with estimates ranging all the way from

2.5 to 0. But all estimates or real-world multipliers are less than the multiplier in our simple text illustrations.

Consumption and Disposable Income, 1985–2011

Each dot in this figure shows consumption and disposable income in a specific year. The line C, which generalizes the

relationship between consumption and disposable income, indicates a direct relationship and shows that households

consume most of their income.

Consumption and Saving Schedules

The two parts of this figure show the income–consumption and income–saving relationships in Table 8-1 graphically.

The saving schedule in part (b) is found by subtracting the consumption schedule in part (a) vertically from the 45°

line. Consumption equals disposable income (and saving thus equals zero) at $390 billion for these hypothetical data.

The Marginal Propensity to Consume and the Marginal Propensity to Save

The MPC is the slope (ΔC/ΔDI) of the consumption schedule, and MPS is the slope (ΔS/ΔDI) of the saving schedule.

The Greek letter delta (Δ) means ―the change in.‖

Shifts in the Consumption and Saving Schedules

Normally, if households consume more at each level of real GDP, they are necessarily saving less. Graphically this

means that an upward shift of the consumption schedule (C0 to C1) entails a downward shift of the saving schedule

(S0 to S1). If households consume less at each level of real GDP, they are saving more. A downward shift of the

consumption schedule (C0 to C2) is reflected in an upward shift of the saving schedule (S0 to S2). (This pattern

breaks down, however, when taxes change; then the consumption and saving schedules shift in the same direction—

opposite to the direction of the tax change.)

The Investment Demand Curve

The investment demand curve is constructed by arraying all potential investment projects in descending order of their

expected rates of return. The curve is downward-sloping, reflecting an inverse relationship between the real interest

rate (the financial ―price‖ of each dollar of investing) and the quantity of investment demanded.

Shifts in the

Investment Demand

Curve

Increases in investment

demand are shown as

rightward shifts in the

investment demand

curve; decreases in

investment demand are

shown as leftward

shifts in the investment

demand curve.

The Multiplier Process (MPC = 0.75)

An initial change in investment

spending of $5 billion creates an equal

$5 billion of new income in round 1.

Households spend $3.75 billion ( =

0.75 × $5 billion) of this new income,

creating $3.75 billion of added income

in round 2. Of this $3.75 billion of new

income, households spend $2.81

billion ( = 0.75 × $3.75 billion), and

income rises by that amount in round

3. The cumulation of such income

increments over the entire process

eventually results in a total change of

income and GDP of $20 billion. The

multiplier therefore is 4 ( = $20 billion

÷ $5 billion).

CHAPTER NINE: THE AGGREGATE EXPENDITURE MODEL

The aggregate expenditures model views the total amount of spending in the economy as the primary factor

determining the level of real GDP that the economy will produce. The model assumes that the price is fixed.

Keynes made this assumption to reflect the reality of the Great Depression, in which declines in output and

employment rather than declines in prices were the dominant adjustments made by firms when they faced

huge declines in their sales.

For a private closed economy, the equilibrium level of GDP occurs when aggregate expenditures and real

output are equal—or, graphically, where the C + Ig line intersects the 45° line. At any GDP greater than

equilibrium GDP, real output will exceed aggregate spending, resulting in unintended investment in

inventories and eventual declines in output and income (GDP). At any below-equilibrium GDP, aggregate

expenditures will exceed real output, resulting in unintended declines in inventories and eventual increases in

GDP.

At equilibrium GDP, the amount households save (leakages) and the amount businesses plan to invest

(injections) are equal. Any excess of saving over planned investment will cause a shortage of total spending,

forcing GDP to fall. Any excess of planned investment over saving will cause an excess of total spending,

inducing GDP to rise. The change in GDP will in both cases correct the discrepancy between saving and

planned investment.

At equilibrium GDP, no unplanned changes in inventories occur. When aggregate expenditures diverge from

GDP, an unplanned change in inventories occurs. Unplanned increases in inventories are followed by a

cutback in production and a decline of real GDP. Unplanned decreases in inventories result in an increase in

production and a rise of GDP.

Actual investment consists of planned investment plus unplanned changes in inventories and is always equal

to saving.

The simple multiplier is equal to the reciprocal of the marginal propensity to save: the greater the marginal

propensity to save, the smaller the multiplier. Also, the greater the marginal propensity to consume, the larger

the multiplier.

A shift in the investment schedule (caused by changes in expected rates of return or changes in interest rates)

shifts the aggregate expenditures curve and causes a new equilibrium level of real GDP. Real GDP changes

by more than the amount of the initial change in investment. This multiplier effect (ΔGDP/ΔIg) accompanies

both increases and decreases in aggregate expenditures and also applies to changes in net exports (Xn) and

government purchases (G).

The net export schedule relates net exports (exports minus imports) to levels of real GDP. For simplicity, we

assume the level of exports is the same at all levels of real GDP.

Positive net exports increase aggregate expenditures to a higher level than they would be if the economy were

―closed‖ to international trade. They raise equilibrium real GDP by a multiple of the net exports. Negative net

exports decrease aggregate expenditures relative to those in a closed economy, decreasing equilibrium real

GDP by a multiple of their amount. Increases in exports or decreases in imports have an expansionary effect

on real GDP, but decreases in exports or increases in imports have a contractionary effect.

Government purchases shift the aggregate expenditures schedule upward and raise GDP.

Taxation reduces disposable income, lowers consumption spending and saving, shifts the aggregate

expenditures curve downward, and reduces equilibrium GDP.

In the complete aggregate expenditures model, equilibrium GDP occurs where Ca + Ig + Xn + G = GDP. At

the equilibrium GDP, leakages of after-tax saving (Sa), imports (M), and taxes (T) equal injections of

investment (Ig), exports (X), and government purchases (G). Also, there are no unplanned changes in

inventories.

The equilibrium GDP and the full-employment GDP may differ. The recessionary expenditure gap is the

amount by which aggregate expenditures fall short of those required to achieve full-employment GDP. This

gap produces a negative GDP gap (actual GDP minus potential GDP). The inflationary expenditure gap is the

amount by which aggregate expenditures exceed those needed to achieve full-employment GDP. This gap

causes demand–pull inflation.

Keynes suggested that the solution to the large negative GDP gap that occurred during the Great Depression

was for government to increase aggregate expenditures. It could do this by increasing its own expenditures

(G) or by lowering taxes (T) to increase after-tax consumption expenditures (Ca) by households. Because the

economy had millions of unemployed workers and massive amounts of unused production capacity,

government could boost aggregate expenditures without worrying about creating inflation.

The stuck-price assumption of the aggregate expenditures model is not credible when the economy

approaches or attains its full-employment output. With unemployment low and excess production capacity

small or nonexistent, an increase in aggregate expenditures will cause inflation along with any increase in real

GDP.

The Investment Demand Curve and the Investment Schedule

(a) The level of investment spending (here, $20 billion) is determined by the real interest rate (here, 8 percent)

together with the investment demand curve ID. (b) The investment schedule Ig relates the amount of investment ($20

billion) determined in part (a) to the various levels of GDP.

Equilibrium GDP in a Private

Closed Economy

The aggregate expenditures

schedule, C + Ig, is determined by

adding the investment schedule Ig

to the upward-sloping

consumption schedule C. Since

investment is assumed to be the

same at each level of GDP, the

vertical distances between C and

C + Ig do not change. Equilibrium

GDP is determined where the

aggregate expenditures schedule

intersects the 45° line, in this case

at $470 billion.

Changes in the Aggregate Expenditure Schedule and the Multiplier Effect.

An upward shift of the aggregate expenditures schedule from (C + Ig)0 to (C + Ig)1 will increase the equilibrium

GDP. A downward shift from (C + Ig)0 to (C + Ig)2 will lower the equilibrium GDP.

Net Exports and the Equilibrium GDP

An increase in net exports raises the aggregate expenditures from (C + Ig + Xn)0 to (C + Ig + Xn)2 and increases the

equilibrium GDP. Conversely, a decrease in net exports shifts the aggregate expenditures schedule downward from (C + Ig + Xn)0 to (C + Ig + Xn)1 and lowers the equilibrium GDP.

Government Spending and the Equilibrium GDP

The addition of government purchases, G, raises the aggregate expenditures (C + Ig + Xn + G) schedule and increases

the equilibrium level of GDP, as would an increase in C, Ig, or Xn.

If the MPC is 0.75, the $40 billion of taxes will lower the domestic consumption schedule by $20 billion and cause a

decline in the equilibrium GDP. In the open economy with government, with Ca representing after-tax income,

equilibrium GDP occurs where Ca + Ig + Xn + G = GDP.

Recessionary and Inflationary Expenditure Gaps

The equilibrium and full-employment GDPs may not coincide. (a) A recessionary expenditure gap is the amount by

which aggregate expenditures fall short of those required to achieve full-employment GDP. Here, the recessionary

expenditure gap is $20 billion, caused by a $10 billion shortfall of aggregate expenditures. (b) An inflationary

expenditure gap is the amount by which aggregate expenditures exceed those needed to achieve full-employment

GDP. Here, the inflationary expenditure gap is $20 billion; this overspending brings about demand–pull inflation.

The Aggregate Expenditures Curve

CHAPTER TEN: AGGREGATE DEMAND AND AGGREGATE SUPPLY

The aggregate demand–aggregate supply model (AD–AS model) is a variable-price model that enables

analysis of simultaneous changes of real GDP and the price level.

The aggregate demand curve shows the level of real output that the economy will purchase at each price

level.

The aggregate demand curve is downward-sloping because of the real-balances effect, the interest-rate effect,

and the foreign-trade effect. The real-balances effect indicates that inflation reduces the real value or

purchasing power of fixed-value financial assets held by households, causing them to retrench on their

consumer spending. The interest-rate effect means that, with a specific supply of money, a higher price level

increases the demand for money, raising the interest rate and reducing consumption and investment

purchases. The foreign-trade effect suggests that an increase in one country's price level relative to other

countries' reduces the net exports component of that nation's aggregate demand.

The determinants of aggregate demand are spending by domestic consumers, businesses, government, and

foreign buyers. Changes in the factors listed in Figure 10-2 alter the spending by these groups and shift the

aggregate demand curve.

The aggregate supply curve shows the levels of real output that businesses will produce at various possible

price levels. The slope of the aggregate supply curve depends upon the flexibility of input and output prices.

Since these vary over time, aggregate supply curves are categorized into three time horizons that have

different underlying assumptions about the flexibility of input and output prices.

The immediate-short-run aggregate supply curve assumes that both input prices and output prices are fixed.

With output prices fixed, the aggregate supply curve is a horizontal line at the current price level. The short-

run aggregate supply curve assumes nominal wages and other input prices remain fixed while output prices

vary. The aggregate supply curve is generally upward-sloping because per-unit production costs, and hence

the prices that firms must receive, rise as real output expands. The aggregate supply curve is relatively steep

to the right of the full-employment output level and relatively flat to the left of it. The long-run aggregate

supply curve assumes that nominal wages and other input prices fully match any change in the price level.

The curve is vertical at the full-employment output level.

Because the short-run aggregate supply curve is the only version of aggregate supply that can handle

simultaneous changes in the price level and real output, it serves well as the core aggregate supply curve for

analyzing the business cycle and economic policy. Unless stated otherwise, all references to ―aggregate

supply‖ refer to the immediate-short-run aggregate supply and the short-run aggregate supply curve.

Figure 10-6 lists the determinants of aggregate supply: input prices, productivity, and the legal–institutional

environment. A change in any one of these factors will change per-unit production costs at each level of

output and therefore alter the location of the aggregate supply curve.

The intersection of the aggregate demand and aggregate supply curves determines an economy's equilibrium

price level and real GDP. At the intersection, the quantity of real GDP demanded equals the quantity of real

GDP supplied.

Increases in aggregate demand to the right of the full-employment output cause inflation and positive GDP

gaps (actual GDP exceeds potential GDP). An upward-sloping aggregate supply curve weakens the effect of

an increase in aggregate demand because a portion of the increase in aggregate demand is dissipated in

inflation.

Shifts of the aggregate demand curve to the left of the full-employment output cause recession, negative GDP

gaps, and cyclical unemployment. The price level may not fall during recessions because of downwardly

inflexible prices and wages. This inflexibility results from fear of price wars, menu costs, wage contracts,

efficiency wages, and minimum wages. When the price level is fixed, in essence there is a horizontal portion

of the aggregate supply curve, referred to as the immediate-short-run aggregate supply curve.

Leftward shifts of the aggregate supply curve reflect increases in per-unit production costs and cause cost–

push inflation, with accompanying negative GDP gaps.

Rightward shifts of the aggregate supply curve, caused by large improvements in productivity, help explain

the simultaneous achievement of full employment, economic growth, and price stability that Canada

experienced between 1996 and 2000, and 2002 and 2008, before giving way to the severe recession that

started in late 2008 and continued into 2009.

Changes in Aggregate Demand

A change in one or more of the listed determinants of aggregate demand will change aggregate demand. An

increase in aggregate demand is shown as a rightward shift of the AD curve, here from AD1 to AD2; a decrease

in aggregate demand is shown as a leftward shift, here from AD1 to AD3.

Aggregate Supply in the Immediate Short Run

In the immediate short run, the aggregate supply curve ASISR is horizontal at the economy's current price level,

P1. With output prices fixed, firms collectively supply the level of output that is demanded at those prices.

Short-Run Aggregate Supply Curve

The upward-sloping aggregate supply curve AS indicates a direct (or positive) relationship between the price

level and the amount of real output that firms will offer for sale. The AS curve is relatively flat below the full-

employment output because unemployed resources and unused capacity allow firms to respond to price-level rises

with large increases in real output. It is relatively steep beyond the full-employment output because resource

shortages and capacity limitations make it difficult to expand real output as the price level rises.

Aggregate Supply in the Long Run The long-run aggregate supply curve ASLR is vertical at the full-employment level of real GDP (GDPf) because in the

long run wages and other input prices rise and match changes in the price level. So price-level changes do not affect

firms' profits and thus they create no incentive for firms to alter their output.

Changes in Short-Run Aggregate Supply

A change in one or more of the listed determinants of aggregate supply will shift the aggregate supply curve. The

rightward shift of the aggregate supply curve from AS1 to AS3 represents an increase in aggregate supply; the leftward

shift of the curve from AS1 to AS2 shows a decrease in aggregate supply.

The Equilibrium Price Level and Equilibrium Real GDP

The intersection of the aggregate demand curve and the aggregate supply curve determines the economy's equilibrium

price level. At the equilibrium price level of 100 (in index-value terms) the $510 billion of real output demanded

matches the $510 billion of real output supplied. So the equilibrium GDP is $510 billion.

An Increase in Aggregate Demand that Causes Demand–Pull Inflation

An increase in aggregate demand generally increases both the GDP and price level. The increase in aggregate demand

from AD1 to AD2 is partly dissipated in inflation (P1 to P2) and real output increases only from GDPf to GDP1.

A Decrease in Aggregate Demand that Causes a Recession If the price level is downwardly inflexible at P1, a decline of aggregate demand from AD1 to AD2 will move the

economy leftward from a to b along the horizontal broken-line segment and reduce real GDP from GDPf to GDP1.

Idle production capacity, cyclical unemployment, and a recessionary GDP gap (of GDPfminus GDP1) will result. If

the price level were flexible downward, the decline in aggregate demand would move the economy from a to c instead

of from a to b.

A Decrease in Aggregate Supply that Causes Cost–Push InflationA leftward shift of aggregate supply from AS1 to

AS2 raises the price level from P1 to P2 and produces cost–push inflation. Real output declines and a negative GDP

gap (of GDPf minus GDP2) occurs.

Growth, Full Employment, and Relative Price Stability

Normally, an increase in aggregate demand from AD1 to AD2 would move the economy from a to b along AS1. Real

output would expand to its full-capacity level (GDPf), and inflation would result (P1 to P3). But in the late 1990s,

significant increases in productivity shifted the aggregate supply curve, as from AS1 to AS2. The economy moved

from a to c rather than from a to b. It experienced strong economic growth (GDP1 to GDP3), full employment, and

only very mild inflation (P1 to P2).

Deriving the Aggregate Demand Curve from the Expenditures Model(a) Rising price levels

from P1 to P2 to P3 shift the aggregate expenditures curve downward from AE1 to AE2 to AE3 and reduce real GDP

from GDP1 to GDP2 to GDP3. (b) The aggregate demand curve AD is derived by plotting the successively lower real

GDPs from the upper graph against the P1, P2, and P3price levels.

Shifts in the Aggregate Expenditures Schedule and in the Aggregate Demand Curve

Part (a): A change in some determinant of consumption, investment, or net exports (other than the price level) shifts

the aggregate expenditures schedule upward from AE1 to AE2. The multiplier increases real output from GDP1 to

GDP2. Part (b): The counterpart of this change is an initial rightward shift of the aggregate demand curve by the

amount of initial new spending (from AD1 to the broken curve). This leads to a multiplied rightward shift of the curve

to AD2, which is just sufficient to show the same increase in GDP as in the aggregate expenditures model.

CHAPTER 11: FISCAL POLICY, DEFICITS, SURPLUSES, and DEBT

Fiscal policy consists of deliberate changes in government spending, taxes, or some combination of both to

promote full employment, price-level stability, and economic growth. Fiscal policy requires increases in government spending, decreases in taxes, or both—a budget deficit—to increase aggregate demand and push

an economy from a recession. Decreases in government spending, increases in taxes, or both—a budget

surplus—are appropriate fiscal policy for decreasing aggregate demand to try to slow or halt demand–pull

inflation.

Built-in stability arises from net tax revenues, which vary directly with the level of GDP. During recession,

the federal budget automatically moves toward a stabilizing deficit; during expansion, the budget

automatically moves toward an anti-inflationary surplus. Built-in stability lessens, but does not fully correct,

undesired changes in the real GDP.

Actual federal budget deficits can go up or down because of changes in GDP, changes in fiscal policy, or

both. Deficits caused by changes in GDP are called cyclical deficits. The cyclically adjusted budget removes

cyclical deficits from the budget and therefore measures the budget deficit or surplus (if either) that would

occur if the economy operated at its full-employment output throughout the year. Changes in the cyclical-

budget deficit or surpluses are those that result from changes in the real GDP.

Changes in the cyclically adjusted deficit or surplus provide meaningful information as to whether the

government's fiscal policy is expansionary, neutral, or contractionary. Changes in the actual budget deficit or

surplus do not, since such deficits or surpluses can include cyclical deficits or surplus.

Certain problems complicate the enactment and implementation of fiscal policy. They include: (a) timing

problems associated with recognition, administrative, and operational lags; (b) the potential for misuse of

fiscal policy for political rather than economic purposes; (c) the tendency for provincial and municipal

finances to be procyclical; (d) potential ineffectiveness if households expect future policy reversals; (e) the

possibility of fiscal policy crowding out private investment; and (f) complications relating to the effects of

fiscal policy on exchange rates and net exports.

Most economists believe that fiscal policy can help move the economy in a desired direction but cannot

reliably be used to fine-tune the economy to a position of price stability and full employment. Nevertheless,

fiscal policy is a valuable backup tool for aiding monetary policy in fighting significant recession or inflation.

The public debt is the total accumulation of all past federal government deficits and surpluses. Foreigners

hold 20 percent of the Canadian portion of the federal debt. In 2011, interest payments as a percentage of

GDP amounted to about 1.9 percent.

The federal government responded to the deep recession of 2008–2009 by implementing an expansionary

fiscal policy.

The concern that a large public debt may bankrupt the Canadian government is generally a baseless worry

because (a) the debt need only be refinanced rather than refunded and (b) the federal government has the

power to increase taxes to make interest payments on the debt.

In general, the public debt is not a vehicle for shifting economic burdens to future generations. Canadians

inherit not only most of the public debt (a liability) but also most of the Canadian securities (an asset) that

finance the debt.

More substantive problems associated with public debt include the following: (a) payment of interest on the

debt may increase income inequality, (b) interest payments on the debt require higher taxes, which may

impair incentives, (c) paying interest or principal on the portion of the debt held by foreigners means a

transfer of real output abroad, and (d) government borrowing to refinance or pay interest on the debt may

increase interest rates and crowd out private investment spending, leaving future generations with a smaller

stock of capital than they would have otherwise.

The increase in investment in public capital that may result from debt financing may partly or wholly offset

the crowding-out effect of the public debt on private investment. Also, the added public investment may

stimulate private investment, where the two are complements.

Expansionary Fiscal Policy

Expansionary fiscal policy uses increases in government spending or tax cuts to push the economy out of recession. In

an economy with an MPC of 0.75, a $5 billion increase in government spending or a $6.67 billion decrease in

personal taxes (producing a $5 billion initial increase in consumption) expands aggregate demand from AD2 to the

downsloping dashed curve. The multiplier then magnifies this initial increase in spending to AD1. So real GDP rises

along the broken horizontal line by $20 billion.

Contractionary Fiscal Policy

Contractionary fiscal policy uses decreases in government spending, increases in taxes, or both, to reduce demand–

pull inflation. Here, an increase in aggregate demand from AD3 to AD4 has driven the economy to point b and

ratcheted the price level up to P2, where it becomes inflexible downward. If the economy's MPC is 0.75 and the

multiplier therefore is 4, the government can either reduce its spending by $3 billion or increase its taxes by $4 billion

(which will decrease consumption by $3 billion) to eliminate the inflationary GDP gap of $12 billion (= $522 billion −

$510 billion). Aggregate demand will shift leftward, first from AD4 to the dashed downsloping curve to its left, and

then to AD5. With the price level remaining at P2, the economy will move from point b to point c and the inflationary

GDP gap will disappear.

Built-in Stability

Tax revenues T vary directly with GDP, and government spending G is assumed to be independent of GDP. As GDP

falls in a recession, deficits occur automatically and help alleviate the recession. As GDP rises during expansion,

surpluses occur automatically and help offset possible inflation.

Cyclically Adjusted Deficits Panel (a): In the left-hand graph, the cyclically adjusted deficit is zero at the full-employment output GDP1. But it is

also zero at the recessionary output GDP2, because the $500 billion of government expenditures at GDP2 equals the

$500 billion of tax revenues that would be forthcoming at the full-employment GDP1. There has been no change in

fiscal policy. Panel (b): In the right-hand graph, discretionary fiscal policy, as reflected in the downward shift of the

tax line from T1 to T2, has increased the cyclically adjusted budget deficit from zero in year 3 (before the tax cut) to

$25 billion in year 4 (after the tax cut). This is found by comparing the $500 billion of government spending in year 4

with the $475 billion of taxes that would accrue at the full-employment GDP3. Such a rise in cyclically adjusted

deficits (as a percentage of GDP) identifies an expansionary fiscal policy.

Fiscal Policy: The Effects of Crowding Out and the Net Export Effect

With an upsloping aggregate supply curve, a part of the impact of an expansionary policy will be reflected in a rise in

the price level rather than an increase in real output and employment.

The Investment Demand Curve and the Crowding-Out Effect

If the investment demand curve (ID1) is fixed, the increase in the interest rate from 6 percent to 10 percent caused by

financing a large public debt will move the economy from a to b and crowd out $10 billion of private investment and

decrease the size of the capital stock inherited by future generations. However, if the government spending enabled by

the debt improves the profit expectations of businesses, the private investment demand curve will shift rightward, as

from ID1 to ID2. That shift may offset the crowding-out effect wholly or in part. In this case, it moves the economy

from a to c.

CHAPTER TWELVE: MONEY, BANKING, and MONEY CREATION

Anything that is accepted as (a) a medium of exchange, (b) a unit of monetary account, and (c) a store of value

can be used as money.

Money is generally defined as demand deposits plus currency (coins and paper money) in circulation (M1).

Demand deposits, the largest component of the money supply, are money because they can be spent by writing

cheques against them. Savings, term, and notice deposits—some chequable and some not—are also money and

are added to more broadly defined monetary aggregates (M2, M2+, and M2++). In our analysis we concentrate

on M1 since its components are immediately spendable.

Money is the debts of government and depository institutions (chartered banks, trust companies, and credit

unions) and has value because of goods, services, and resources it will command in the market. Maintaining

the purchasing power of money depends largely on the government's effectiveness in managing the money

supply.

The Canadian banking system is composed of (a) the Bank of Canada and (b) 20 Canadian-owned and 27

foreign-owned chartered banks. The chartered banks of the economy accept money deposits and make loans. The Canadian banking system is concentrated compared to other nations, particularly the United States.

The U.S. financial crisis of 2007–2008 consisted of an unprecedented rise in mortgage loan defaults, the

collapse or near-collapse of several major financial institutions, and the generalized freezing up of credit

availability. The crisis resulted from bad mortgage loans together with declining real estate prices. It also

resulted from underestimation of risk by holders of mortgage-backed securities and faulty insurance securities

designed to protect holders of mortgage-backed securities from the risk of default.

Modern banking systems are fractional reserve systems: only a fraction of deposits are backed by currency.

The operation of a chartered bank can be understood through its balance sheet, where assets equal liabilities

plus net worth.

Chartered banks keep cash reserves as vault cash and a small amount in the Bank of Canada for cheque-

clearing purposes. This reserve is equal to a desired percentage of the chartered bank's deposit liabilities.

Excess cash reserves are equal to actual reserves minus desired cash reserves.

Banks lose both cash reserves and deposits when cheques are drawn against them.

Chartered banks create money—create demand deposits, or deposit money—when they make loans. They

convert IOUs, which are not money, into demand deposits, which are money. Money is destroyed when bank

loans are repaid.

The ability of a single chartered bank to create money by lending depends on the size of its excess cash

reserves. Generally speaking, a chartered bank lends only an amount equal to the amount of its excess cash

reserves.

Rather than making loans, chartered banks may decide to use excess cash reserves to buy bonds from the

public. In doing so, banks merely credit the demand deposit accounts of the bond sellers, thus creating demand

deposit money. Money vanishes when banks sell bonds to the public because bond buyers must draw down

their demand deposit balances to pay for the bonds.

Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by holding excess cash

reserves. Banks with temporary excess reserves often lend them overnight to banks that are short of desired

cash reserves. The interest rate paid on loans in this market is called the overnight lending rate.

The chartered banking system as a whole can lend by a multiple of its excess cash reserves because the

banking system cannot lose cash reserves, although individual banks can lose cash reserves to other banks in

the system.

The multiple by which the banking system could lend on the basis of each dollar of excess cash reserves is the

reciprocal of the desired reserve ratio. This multiple credit expansion process is reversible.

Components of Money Supply M1, M2, M2 +, and M2++ in Canada

M1 is a narrow definition of the money supply that includes currency (in circulation) and demand deposits. M2,

M2+, and M2++ are broader definitions that include M1 along with several other account balances.

CHATER THIRTEEN: INTEREST RATES AND MONETARY POLICY

The total demand for money consists of the transactions demand and the asset demand for money. The amount

of money demanded for transactions varies directly with the nominal GDP; the amount of money demanded as

an asset varies inversely with the interest rate. The market for money combines the total demand for money

with the money supply to determine equilibrium interest rates.

Interest rates and bond prices are inversely related.

The major functions of the Bank of Canada are to (a) be a lender of last resort (bankers' bank) to the chartered

banks, (b) supply the economy with paper currency, (c) act as the fiscal agent for the federal government, (d)

supervise the operations of chartered banks (together with the Department of Finance), and (e) regulate the

supply of money.

The Bank of Canada's major asset is Government of Canada securities. Its three major liabilities are chartered

bank reserves, Government of Canada deposits, and notes in circulation.

The goal of monetary policy is price stability. Full employment and economic growth are secondary objectives

that follow directly from price stability.

In regard to monetary policy, the most important assets of the Bank of Canada are Government of Canada

bonds and Treasury bills.

The two instruments of monetary policy are open-market operations and the bank rate. The instrument used

most often is open-market operations.

The overnight lending rate is the interest rate that banks charge one another for overnight loans of reserves.

The prime interest rate is banks' benchmark rate for a wide range of interest rates on short-term loans to

businesses and individuals.

The Bank of Canada adjusts the overnight rate to a level appropriate for economic conditions. In an

expansionary monetary policy, it purchases securities from chartered banks and the general public to inject

reserves into the banking system. This lowers the overnight rate to the targeted level and also reduces other

interest rates (such as the prime rate). In a restrictive monetary policy, the Bank of Canada sells securities to

chartered banks and the general public via open-market operations. Consequently, reserves are removed from

the banking system, and the overnight rate and other interest rates rise.

Monetary policy operates through a complex cause–effect chain: (a) policy decisions affect chartered bank

reserves; (b) changes in reserves affect the supply of money; (c) changes in the money supply alter the interest

rate; (d) changes in the interest rate affect investment; (e) changes in investment affect aggregate demand; (f)

changes in aggregate demand affect equilibrium real GDP and the price level. Table 13.2 draws together all the

basic notions relevant to the use of monetary policy.

The advantages of monetary policy include its flexibility and political acceptability.

In the recent past, the Bank of Canada has adroitly used monetary policy to hold inflation in check as the

economy boomed, avoided recession in the economic slowdown of 2001, and hastened economic recovery.

During the Great Recession of 2008–2009, monetary policy in Canada prevented the recession from becoming

more severe and adroitly nursed the Canadian economy back to health.

Today, nearly all economists view monetary policy as a significant policy tool.

Monetary policy has two limitations and potential problems: (1) recognition and operational lags complicate

the timing of monetary policy; and (2) in a severe recession, the reluctance of banks to lend excess reserves

and firms to borrow money to spend on capital goods may contribute to a liquidity trap that limits the

effectiveness of an expansionary monetary policy.

The effect of an expansionary monetary policy on domestic GDP is strengthened by the increase in net exports

that results from a lower domestic interest rate. Likewise, a tight money policy is strengthened by a decline in

net exports. Depending on the situation, there may be a conflict or complementarity between monetary policy's

effects on the domestic and international economies.

The Demand for Money, the Supply of Money, and the Equilibrium Interest RateThe total demand for money Dm is

determined by horizontally adding the asset demand for money Da to the transactions demand Dt. The transactions demand

is vertical because it is assumed to depend on nominal GDP rather than on the interest rate. The asset demand varies

inversely with the interest rate because of the opportunity cost involved in holding currency and chequable deposits that pay

no interest or very low interest. Combining the money supply (stock) Sm with total money demand Dm portrays the money

market and determines the equilibrium interest rate ie.

Targeting the Overnight Lending Rate

In implementing monetary policy, the Bank of Canada determines a desired overnight lending rate and then uses open-

market operations (buying and selling of securities) to add or subtract chartered bank reserves to achieve and maintain that

targeted rate. In an expansionary monetary policy, the Bank of Canada increases the supply of reserves, for example,

from Sf1 to Sf3 in this case, to move the overnight lending rate from 4 percent to 3.5 percent. In a restrictive monetary policy,

it decreases the supply of reserves, say, from Sf1 to Sf3. Here, the overnight lending rate rises from 4 percent to 4.5 percent.

Monetary Policy and Equilibrium GDPAn expansionary monetary policy that shifts the money supply curve rightward

from Sm1 to Sm2 in part (a) lowers the interest rate from 10 percent to 8 percent in part (b). As a result, investment spending

increases from $15 billion to $20 billion, shifting the aggregate demand curve rightward from AD1 to AD2in part (c) so that

real output rises from the recessionary level of GDP1 to the full-employment level at GDPf along the horizontal line. In part

(d), the economy at point a has an inflationary gap, and thus GDP is above potential output. A restrictive monetary policy

that shifts the money supply curve leftward fromSm3 = $175 billion to just $162.5 billion in part (a) will increase the interest

rate from 6 percent to 7 percent. Investment spending thus falls from $25 billion to $22.5 billion in part (b). The aggregate

demand curve shifts leftward in part (d) from AD3 to AD4, moving the economy along the horizontal line to equilibrium

point b. This returns the economy to full-employment output and eliminates the inflationary gap.

CHAPTER SIXTEEN: INTERNATIONAL TRADE

Goods and services flows, capital and labour flows, information and technology flows, and financial flows link

Canada and other countries.

International trade is growing in importance globally and for Canada. World trade is significant to Canada in

two respects: (a) Canadian imports and exports as a percentage of domestic output are among the highest in the

world; and (b) Canada is completely dependent on trade for certain commodities and materials that cannot be

obtained domestically.

Principal Canadian exports include automotive products, machinery and equipment, and grain; major Canadian

imports are general machinery and equipment, automobiles, and industrial goods and machinery.

Quantitatively, the United States is our most important trading partner.

Global trade has been greatly facilitated by (a) improvements in transportation technology, (b) improvements

in communications technology, and (c) general declines in tariffs. The world's major trading nations by volume

of trade are China, the United States, Germany, and Japan. Other major traders include other Western

European nations (France, Netherlands, Italy, and the United Kingdom), along with Canada and the Southeast

Asian countries of South Korea, Taiwan, and Singapore.

World trade is based on three considerations: (1) the uneven distribution of economic resources among nations,

(2) the fact that efficient production of various goods requires particular techniques or combinations of

resources, and (3) the differentiated products produced among nations.

Mutually advantageous specialization and trade are possible between any two nations if they have different

opportunity-cost ratios for any two products. By specializing based on comparative advantage, nations can

obtain larger real incomes with fixed amounts of resources. The terms of trade determine how this increase in

world output is shared by the trading nations. Increasing (rather than constant) costs limit specialization and

trade.

A nation's export supply curve shows the quantity of product it will export at world prices that exceed the

domestic price—the price in a closed, no-international-trade economy. Its import demand curve reveals the

quantity of a product it will import at world prices below the domestic price.

In a two-nation model, the equilibrium world price and the equilibrium quantities of exports and imports occur

Trade barriers take the form of protective tariffs, quotas, nontariff barriers, and ―voluntary‖ export restrictions.

Export subsidies also distort international trade. Supply and demand analysis demonstrates that protective

tariffs and quotas increase the prices and reduce the quantities demanded of affected goods. Sales by foreign

exporters diminish; domestic producers, however, enjoy higher prices and enlarged sales. Consumer losses

from trade restrictions greatly exceed

The strongest arguments for protection are the infant industry and military self-sufficiency arguments. Most

other arguments for protection are interest-group appeals or reasoning fallacies that emphasize producer

interests over consumer interests or stress the immediate effects of trade barriers while ignoring long-run

consequences.

The cheap foreign labour argument for protection fails because it focuses on labour costs per hour rather than

on what really matters, labour costs per unit of output. Due to higher productivity, firms in high-wage countries

like Canada can have lower wage costs per unit of output than competitors in low-wage countries. Whether

they do will depend on how their particular wage and productivity levels compare with those of their

competitors in low-wage countries.

In 1947 the General Agreement on Tariffs and Trade (GATT) was formed to encourage nondiscriminatory

treatment for all member nations, to reduce tariffs, and to eliminate import quotas. The Uruguay Round of

GATT negotiations (1993) reduced tariffs and quotas, liberalized trade in services, reduced agricultural

subsidies, reduced pirating of intellectual property, and phased out quotas on textiles.

GATT's successor, the World Trade Organization (WTO), had 155 member nations in 2012. It implements

WTO agreements, rules on trade disputes between members, and provides forums for continued discussions on

trade liberalization. The latest round of trade negotiations—the Doha Development Agenda—began in late

2001 and as of 2012 was still in progress.

Free-trade zones (trade blocs) liberalize trade within regions. Two examples of free-trade agreements are the

27-member European Union (EU) and the North American Free Trade Agreement (NAFTA) comprising

Canada, Mexico, and the United States. Seventeen of the EU nations have agreed to abandon their national

currencies for a common currency called the euro.

Production Possibilities Curve

Trading Possibilities Lines and the Gains from Trade

Canadian Export Supply and Import Demand

U.S. Export Supply and Import Demand

Equilibrium World Price and Quantity of Exports and Imports

The Economic Effects of a Protective Tariff or an Import Quota

CHAPTER SEVENTEEN: EXCHANGE RATES and THE BALANCE OF PAYMENTS

International financial transactions involve trade either in currently produced goods and services or in pre-

existing assets. Exports of goods, services, and assets create inflows of money, while imports cause outflows of

money. If buyers and sellers use different currencies, then foreign exchange transactions take place so that the

exporter can be paid in his or her own currency.

The balance of payments records all international trade and financial transactions taking place between a given

nation and the rest of the world. The trade balance compares exports and imports of goods. The balance on

goods and services compares exports and imports of both goods and services. The current account balance

includes not only goods and services transactions but also net investment income and net transfers.

The capital and financial account includes (a) the net amount of the nation's debt forgiveness and (b) the

nation's sale of real and financial assets to people living abroad less its purchases of real and financial assets

from foreigners.

The current account and the capital and financial account always sum to zero. A deficit in the current account

is always offset by a surplus in the capital and financial account. Conversely, a surplus in the current account is

always offset by a deficit in the capital and financial account.

Official international reserves are owned by national governments and their central banks and consist of stocks

of foreign currencies, certain reserves held with the International Monetary Fund, and stocks of gold.

A balance of payments deficit occurs when the sum of the current and capital accounts is negative. Such a

deficit is financed with official international reserves. A balance of payments surplus occurs when the sum of

the current and capital accounts is positive. A payments surplus results in an increase in official international

reserves. The desirability of a balance of payments deficit or surplus depends on its size and its persistence.

Flexible or floating exchange rates between international currencies are determined by the demand for and

supply of those currencies. Under floating rates a currency will depreciate or appreciate as a result of changes

in tastes, relative income changes, relative changes in inflation rates, relative changes in real interest rates, and

speculation.

The maintenance of fixed exchange rates requires adequate official international reserves to accommodate

periodic payments deficits. If reserves are inadequate, nations must invoke protectionist trade policies.

Since 1971, the world's major nations have used a system of managed floating exchange rates. Rates are

generally set by market forces, although governments intervene with varying frequency to alter their exchange

rates.

The Market for Foreign Currency (Pounds)

Adjustments under Flexible Exchange Rates

Adjustments under Fixed Exchange Rates